Don’t Overlook These Legal and Financial Considerations When Selling Your Business

A successful exit doesn’t happen by mistake! Along the way, there are several important elements to navigate, including the legal and financial considerations related to selling your business. Knowing what to expect from a legal and financial standpoint is an essential part of a successful exit.

In this article, we discuss:

• Key legal implications of selling your business
• The most important financial considerations when selling your business
• What to consider when hiring legal help to sell your business

Related Article: How to Get Your Business Ready to Sell

Key Legal Implications of Selling Your Business

As a business owner, you may be wondering, “What are the legal implications of selling my business?” There are a number of legal matters to consider when it comes to planning your exit. One of the first steps is understanding the legal due diligence process. In addition, it is helpful to be aware of several relevant legal documents. 

Legal and financial considerations: Legal due diligence

When a business is bought and sold, both parties have an interest in making sure the deal is safe and secure. In order to achieve this, the transaction process involves a stage known as due diligence. During this phase, the buyer and their team comb through the business in order to assess all aspects of its performance.

 

Legal due diligence is one part of this process. It is an opportunity for the prospective buyer to assess the business’s legal practices. Generally, they’ll want to examine:

• Employment contracts and contractor agreements
• Supplier agreements
• Warranties
• Intellectual property protection
• Intellectual property infringements
• Distribution agreements
• Compensation practices
• Accounting practices and financial statements
• Pending lawsuits

In addition, regardless of whether your business is an S corporation, C corporation, LLC, or sole proprietorship, the buyer will inspect your articles of incorporation or other formation documents to ensure everything is in order. 

While legal due diligence is initiated and carried out by the buyer and their team, it is also an important step for you as the seller. Thoroughly completing legal due diligence helps reduce the likelihood of future issues. 

As the seller, it is your responsibility to help the buyer complete the legal due-diligence process. This includes answering all of their questions and providing them with requested information in a timely manner. 

To facilitate the due-diligence process, it’s wise to prepare all relevant information beforehand. This ensures you’re ready to go when the time is right.

Due diligence aside, there are a number of legal documents that are involved in the transaction process. 

Legal and financial considerations: Letter of intent

The letter of intent occurs after a potential buyer learns about your business. It also occurs before the due-diligence process begins. While the LOI is not a legally binding document, it does spell out the terms of a potential future deal. 

Essentially, it states that the buyer and seller intend to move forward with the transaction as long as certain conditions are met. The letter of intent likely would include the final purchase price, expected closing date, and key elements of the final agreement. It may also include an exclusivity period during which the seller cannot entertain other offers. 

Legal and financial considerations: Asset purchase agreement

The asset purchase agreement is the final, legally binding agreement between you and the buyer. It spells out the conditions of the sale in clear terms. As such, it is the most important legal document involved in the transaction process. 

While the letter of intent spells out the general terms of the agreement, the terms can change as a result of information discovered during due diligence. For this reason, the asset purchase agreement is generally drafted and finalized after due diligence. 

At times, however, the buyer and seller may agree to create an interim asset purchase agreement prior to due diligence, and then make any changes if necessary after due diligence is complete.

Promissory note

A promissory note is used when the transaction involves seller financing. The promissory note spells out the terms and conditions of the financing structure. This includes the amount to be paid, payment schedule, interest rate, and default repercussions of the deal. Since promissory notes are used with seller financing, not all transactions require one. 

Asset allocation agreement

When you sell your business, all of the assets included in the sale are classified as either capital assets or noncapital assets. In addition, each asset is assigned a value. Assigning value and classification is handled in the asset allocation agreement. 

As we will see in the next section, the value and classification of assets included in the sale have a significant impact on your post-sale tax implications. For this purpose, it is important to work with an accountant during the creation of the asset allocation agreement. This will help to ensure that the agreement is created in an appropriate manner. It will also help you understand what you can expect in regard to your tax burden as a result of the sale. 

“When you sell your business, all of the assets included in the sale are classified as either capital assets or noncapital assets.”

Non-compete agreement

Many business transactions include a non-compete agreement. This agreement simply states that you, as the seller, cannot start a business or engage in certain activities that would directly compete with the new owner. 

The exact activities that you can and cannot perform with regard to competing with the new owner will depend on the outcome of negotiations with the buyer. 

Bill of sale

Once the final agreement has been drafted and all funds and assets have been transferred, you and the buyer draft and sign a bill of sale. The bill of sale formally acknowledges that all payments and assets have been transferred and received by both parties. It serves to prevent future claims that one party has not fully delivered or transferred the agreed-upon assets or funds. 

The Most Important Legal and Financial Considerations When Selling Your Business

From personal finances to post-sale taxes, there are a number of financial considerations. These are important when it comes to making an informed decision. 

Income taxes vs capital gains taxes

When you sell your business you will need to pay income taxes, capital gains taxes, or both. The exact breakdown of income taxes vs capital gains taxes will depend on the breakdown of your income from the sale of the business.

As mentioned above, the assets you include in the sale will be classified as either capital assets or noncapital assets. Any income, or capital gain, that derives from the sale of capital assets is taxed as capital gains income. Income that derives from the sale of noncapital assets is taxed as ordinary income.

This is important because the capital gains tax brackets differ significantly from income tax brackets. The capital gains tax rate is currently quite a bit lower than the normal income tax rate. At the present time, the income tax rate ranges from 10 percent on the low end to 37 percent on the high end. For capital gains taxes, the tax rate ranges from 0–20 percent.

As such, it is in your interest as the seller to have as many of your assets as possible classified and sold as capital assets. However, you must always abide by IRS rules when creating the asset allocation agreement. 

“When you sell your business you will need to pay income taxes, capital gains taxes, or both.”

How your payment structure can impact your tax burden

The deal structure when selling your business can have an impact on the total amount of taxes you pay. At times, the full amount of the purchase price may be paid all at once at the time of closing. Other deal structures allow for a series of payments to be made according to an agreed-upon schedule. 

While many sellers prefer to receive the full amount up front, there can be advantages to spreading it out over several payments. Depending on the sale price and payment schedule, it may be possible to set each payment to a lower amount so that it falls into a lower tax bracket. In the long run, this can help to significantly lower your overall tax burden as a seller. 

Exit timing and taxes

The timing with which you sell your business can also have an impact on your tax burden. If you sell during a year when your business incurs significant costs or losses, it can offset the income that you receive from the sale. This can help to reduce your total taxable income, and thus lower your tax rate and amount.

There are disadvantages to this strategy, however. Selling during a bad year can negatively impact your business valuation. For this reason, you must decide whether the potential tax benefits outweigh the potential decrease in business value and sale price. 

Personal finances

Taxes aside, it is also important to consider how your personal financial situation will change when you sell your business. If you were drawing a monthly or yearly income from the business, consider how you will balance your finances when you no longer have this cash flow.

Depending on the value of your business at the time of sale, you may be receiving a significant amount of money. Having an idea of what you plan to use this for ahead of time can help you successfully move on to your post-sale life. 

“Taxes aside, it is also important to consider how your personal financial situation will change when you sell your business.”

What to Consider When Hiring Legal Help to Sell Your Business

Many business owners wonder whether or not they need to seek legal advice when selling their business and, if so, what kind of assistance they should seek.

Hiring a business broker, or Advisor, to facilitate the exit process is often a wise decision. Similar to a real estate agent when selling a house, your Advisor will help guide you through every step of the selling process. This includes preparing your business for the market, finding qualified buyers, negotiating terms, and closing the deal. They can also help walk you through the various legal and financial considerations related to the process.

A qualified Advisor is also a valuation expert. They can help you create an accurate and thorough valuation of your business prior to listing. From the valuation, they can also help you get a better understanding of how you can optimize your business in order to get top dollar. 

“Your Advisor can also help you determine whether or not you need to hire additional legal counsel throughout the process.”

If you do decide to use the help of a business Advisor, you must compensate them for their services. This is often structured as a small percentage of the proceeds from the sale of the business. While this does add cost to the transaction process, a good Advisor should more than make up for their fee by helping you achieve a higher sale price and win more favorable deal terms.

Your Advisor can also help you determine whether or not you need to hire additional legal counsel throughout the process. If you do, they can assess if a given individual is right for the job and whether the associated legal fee is reasonable or not.